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Yale Law School

Center for Law, Economics and Public Policy Research Paper No. 300

What is Corporate Law?

Henry Hansmann Reinier Kraakman

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Kraakman / The Anatomy of Corporate Law Final Proof 25.2.2004 8:38am page 1

What is Corporate Law?
HENRY HANSMANN and REINIER KRAAKMAN 1.1 Introduction What is the common structure of the law of business corporations—or, as it would be put in the UK, company law—across different national jurisdictions? Although this question is rarely asked by corporate law scholars, it is critically important for the comparative investigation of corporate law. Recent scholarship emphasizes the divergence among European, American, and Japanese corporations in corporate governance, share ownership, capital markets, and business culture.1 But, notwithstanding the very real differences across jurisdictions along these dimensions, the underlying uniformity of the corporate form is at least as impressive. Business corporations have a fundamentally similar set of legal characteristics—and face a fundamentally similar set of legal problems—in all jurisdictions. Consider, in this regard, the basic legal characteristics of the business corporation. To anticipate our discussion below, there are five of these characteristics, most of which will be easily recognizable to anyone familiar with business affairs. They are: legal personality, limited liability, transferable shares, delegated management under a board structure, and investor ownership. These characteristics are—for reasons we will explore—induced by the economic exigencies of the large modern business enterprise. Thus, corporate law everywhere must, of necessity, provide for them. To be sure, there are other forms of business enterprise that lack one or more of these characteristics. But the remarkable fact—and the fact that we wish to stress—is that, in market economies, almost all large-scale business firms adopt a legal form that possesses all five of the basic characteristics of the business corporation. Indeed, most small jointly-owned firms adopt this corporate form as well, although sometimes with deviations from one or more of the five basic characteristics to fit the special needs of closely held firms. (Throughout this book, we will follow the usual
1 See, e.g., Ronald J. Gilson and Mark J. Roe, Understanding the Japanese Keiretsu: Overlaps Between Corporation Governance and Industrial Organization, 102 Yale Law Journal 871 (1993); Mark J. Roe, Some Differences in Corporation Structure in Germany, Japan, and the United States, 102 Yale Law Journal 1927 (1993); Bernard S. Black and John C. Coffee, Hail Britannia? Institutional Investor Behavior Under Limited Regulation, 92 Michigan Law Review 1997 (1994); Klaus J. Hopt and Eddy Wymeersch (eds.), Comparative Corporate Governance: Essays and Materials (1997); and Mark J. Roe, Political Determinants of Corporate Governance (2003).

since it is the form that is chosen by most large-scale enterprises—and. and thus lowers the costs of business contracting. we briefly explore the contracting efficiencies (some familiar and some not) that accompany these five features of the corporate form. Nevertheless.2004 8:38am page 2 2 Introduction practice of using the term ‘closely held’ to refer to corporations whose shares— unlike those of ‘publicly held’ corporations—do not trade freely in impersonal markets.3 Moreover. the only form that widely held firms can choose in many jurisdictions. In particular. have helped to propel the worldwide diffusion of the corporate form. we address three principal conflicts within the corporation: those between managers and shareholders. it faces the same generic agency problems that confront all jointly-owned firms. By making this form widely available and user-friendly—i. but rather on a second. by altering background property rights2 and providing off-the-shelf housekeeping rules—corporate law enables entrepreneurs to transact easily through the medium of the corporate entity. 3 Only the corporate form is available in many jurisdictions to the extent that large-scale enterprises are forced to look to the public equity markets for financing. in the U. .) Self-evidently. as a practical matter. we believe.. Of course. We agree. both in general and as they arise in the corporate context. All three of these generic conflicts give rise to problems that are usefully characterized as what economists call ‘agency problems. our principal focus in this book is not on establishing the corporate form per se. In this Chapter.Kraakman / The Anatomy of Corporate Law Final Proof 25. and surveys the range of legal strategies that can be employed to deal with those problems. equally important function of corporate law: that is. either because the shares are held by a small number of persons or because they are subject to restrictions that limit their transferability. The Essential Role of Organizational Law.’ After all. the number of provisions that the typical corporation statute devotes to defining the corporate form is likely to be only a small part of the statute as a whole. including creditors and employees. the equity securities of so-called ‘master’ limited partnerships and limited liability companies may be registered for public trading. and that. the characteristics of this particular form matter a great deal. The reader might object that these agency conflicts—which.2. occupy most of corporate law—are not uniquely ‘corporate. 110 Yale Law Journal 387 (2000). constraining value-reducing forms of opportunism among the constituencies of the corporate enterprise. those among shareholders. Like corporate law itself. and those between shareholders and the corporation’s other constituencies. in our view. managers.e. Nevertheless. Chapter 2 examines these three agency problems. these are the provisions that comprise the legal core of corporate law that is shared by every jurisdiction. the unique 2 See Henry Hansmann and Reinier Kraakman. insofar as the corporation is only one of several legal forms for the jointly-owned firm. however. any form of jointly-owned enterprise must expect conflicts among its owners.’ Consequently.S.. Some jurisdictions permit the equity of non-corporate entities to trade in the public markets as well: for example. and third-party contractors. a principal function of corporate law is to provide business enterprises with a legal form that possesses these five core attributes.

making the corporate form practicable—in the most important categories of corporate actions and decisions. respectively.2. including France. Taken together. Japan.. both in the field of corporate law and elsewhere. Chapters 3–8 address. In each Chapter.S.. 1 German Economic Review 187 (2000). Burcin Yurtoglu. we describe how the basic agency problems of the corporate form manifest themselves in the given category of corporate activity. both alone and in comparison with each other.4 We join an emerging tendency in comparative law scholarship by seeking to give a highly integrated view of the role and structure of corporate law that provides a clear framework within which to organize an understanding of individual systems. its owners. again. Pinto and Gustavo Visentini (eds. Similarly. and the other parties with whom it deals.2004 8:38am page 3 What is Corporate Law? 3 features of this form determine the contours of its agency problems. six categories of transactions and decisions that involve the corporation. say. and then explore the range of alternative legal responses that are available. For example. though we also make reference to the law of other jurisdictions to make special points. from the fundamental project of establishing the corporate form itself. e. the latter six chapters of our book cover nearly all of the important problems in corporate law—apart. We explore the patterns of homogeneity and the patterns of heterogeneity that appear. . As before. Country Legal Environments and Corporate Investment Performance. general partners in a partnership do not—has traditionally made creditor protection far more salient in corporate law than it is in partnership law. while Chapter 4 turns to the checks that operate on the corporation’s transactions with creditors.5 Moreover. Where there are significant differences across jurisdictions. In emphasizing a strongly functional approach to the issues of comparative law. that is. the response of corporate law turns in part on the unique legal features that characterize the corporate form. however. we seek to address both the sources and the consequences of those differences. To take an obvious example. rather than uniquely corporate. 5 Other examples of this trend include Dennis C. More particularly. Arthur R. this book differs from some of the more traditional comparative law scholarship. and so has sharpened the management–shareholder agency problem. we explore the role of corporate law in minimizing agency problems—and thus. the fact that shareholders enjoy limited liability—while. and the UK. We illustrate these alternative approaches with examples from the corporate law of various prominent jurisdictions. generic.g. In this book. the U. Mueller and B.Kraakman / The Anatomy of Corporate Law Final Proof 25. Most of these categories of firm activity are.). The Legal Basis of Corporate Governance in Publicly Held Corporations. while comparative 4 Compare. A Comparative Approach (1998). if similar agency problems arise in similar contexts across all forms of jointly-owned enterprise. the fact that corporate investors may trade their shares is the foundation of the anonymous trading stock market—an institution that has encouraged the separation of ownership from control. its managers. Our examples are drawn principally form a handful of major representative jurisdictions. Chapter 3 addresses the governance mechanisms that operate over the firm’s ordinary business decisions. Germany.

Ugo Mattei.2. and with which to compare and evaluate the efficacy of different legal regimes in serving those purposes. However. Vishny. 106 Journal of Political Economy 1113 (1998). we need not commit ourselves on fine points of social science methodology. we offer a more expansive account than do other commentators of the functions of central features of the corporate form such as limited liability and the governance structure of the corporate board. and most obviously. competition. . illuminates an underlying commonality of structure that transcends national boundaries. Second. we wish to offer a common language and a general analytic framework with which to understand the purposes that can potentially be served by corporate law. Corporate Law (1986). is informed not only by a comparative perspective across jurisdictions. but that it will be equally valuable Rafael La Porta. our analysis differs from—and goes beyond—that offered by these and other commentators in several key respects. but also by a comparative perspective across legal forms for business enterprise. Florencio Lopez-de-Silanes. our approach is to focus on similarities. imitation. The Functions of Trust Law: A Comparative Legal and Economic Analysis. it is our hope that the analysis offered in this book will be of use not only to students of comparative law. law. our approach echoes that taken by Dean Robert Clark in his important treatise. we present a comparative analysis that addresses the corporate law of multiple jurisdictions. 1998). we provide an integrated functional overview that stresses the agency problems at the core of corporate law. Konrad Zweigert and Hein Kotz. ¨ translated from the German by Tony Weir.6 Indeed. to be as wary of ‘economic analysis’ as they are of ‘functional analysis. Comparative Law and Economics (1997). rather than focusing on more particular legal institutions and solutions. That is not to say that our objective here is just to explore the commonality of corporate law across jurisdictions. Andrei Shleifer and Robert W.S. that corporate law everywhere must necessarily address these problems. however.’ For the purposes at hand. particularly outside of the United States. and Frank Easterbrook and Daniel Fischel. Henry Hansmann and Ugo Mattei. The Economic Structure of Corporate Law (1991). We need simply note that the exigencies of commercial activity and organization present practical problems that have a rough similarity in developed market economies throughout the world. in their more recent discussion of U.’ though the sometimes tendentious use of economic argumentation in legal literature has also caused many scholars. moreover. means different things to different people.2004 8:38am page 4 4 Introduction law scholarship often has a tendency to emphasize differences between jurisdictions. we believe.Kraakman / The Anatomy of Corporate Law Final Proof 25. It also provides important perspective on the potential basis for the international integration of corporate law that must necessarily take place as economic activity continues to become more global in scope in the decades to come. and that some of the uses to which that term has been put in the past—particularly in the field of sociology—have made the term justifiably suspect. Introduction to Comparative Law (3rd ed. Law and Finance. and compatibility tend to lead different jurisdictions to choose roughly similar solutions to these problems. It would perhaps be more accurate to call our approach ‘economic’ rather than ‘functional. We realize that the term ‘functional. Of equal importance. 6 In very general terms. First.’ which we have used here and in our title. Our analysis. interest group pressure. 73 New York University Law Review 434 (1998). and that the forces of logic. Finally. Doing so.

provide mechanisms for restricting the transferability of shares—such as those 7 Compare Lucian A. Bebchuk and Mark J.8 Rather.7 That is a subject on which reasonable minds can differ. we take no strong stand here in the current debates on the extent to which corporate law is or should be ‘converging. Roe. Bratton and Joseph A. As this pattern suggests. (3) transferable shares. Together. (4) centralized management under a board structure. 38 Columbia Journal of Transnational Law 213 (1999). 52 Stanford Law Review 127 (1999). . there is a basic statute that provides for the formation of firms with all of these characteristics. we are seeking to set out a conceptual framework and a factual basis with which that and other important issues facing corporate law can be fruitfully explored. John C. Coffee. A Theory of Path Dependence in Corporate Ownership and Governance. Licht.2004 8:38am page 5 What is Corporate Law? 5 to those who simply wish to have a more solid framework within which to view their own country’s corporation law. Gilson. William M. Other times these firms are formed under special ‘close’ corporation statutes that. Globalizing Corporate Governance: Convergence of Form or Function. these characteristics have strongly complementary qualities for many firms. 93 Northwestern University Law Review 641 (1999). In virtually all economically important jurisdictions. 49 American Journal of Comparative Law 329 (2001). in addition. and Amir N. the five core structural characteristics of the business corporation are: (1) legal personality. 26 Delaware Journal of Corporate Law 147 (2001). it is a subject on which the reasonable minds that have written this book sometimes differ. Likewise. Indeed. (2) limited liability. McCahery. The Future as History: The Prospects for Global Convergence in Corporate Governance and its Significance.Kraakman / The Anatomy of Corporate Law Final Proof 25. Ronald J. firms that have only some but not all of these characteristics are also commonplace. 8 The views of the principal authors of this chapter are briefly set out in Henry Hansmann and Reinier Kraakman. taking advantage of the statute’s flexibility to omit one or more of the characteristics that are provided for simply as defaults.’ much less on what it might converge to. But these characteristics also generate tensions and tradeoffs that lend a distinctively corporate character to the agency problems that corporate law must address.2. Sometimes these firms are formed under a jurisdiction’s basic corporation statute. and (5) shared ownership by contributors of capital. at least as the default regime. 89 Georgetown Law Journal 439 (2001). Comparative Corporate Governance and the Theory of the Firm: The Case Against Global Cross Reference. This is to say that firms formed under the statute will have these characteristics unless (if the statute permits) those who form the firm make explicit provision for omitting one or more of them. they make the corporation uniquely attractive for organizing productive activity. 1. While our principal focus is on companies that share all five of these core characteristics. The End of History for Corporate Law.2 What is a Corporation? As we noted above. The Mother of All Path Dependencies: Toward a Cross-Cultural Theory of Corporate Governance Systems.

with virtually no restraints imposed on the choices that can be made. Other features of an organization formed under the Act—including the governance structure and rights to earnings and assets—are left to be specified (in the certificate of trust) by the firm’s organizers.1 Legal personality As an economic entity. See..g. Principals and Agents: . other jurisdictions have elements of group law as well. Hopt (ed. and Economic Organization.2.). Agency Costs and Ownership Structure.Kraakman / The Anatomy of Corporate Law Final Proof 25. Most of the larger firms organized under these statutes are full corporations in precisely the sense that we intend. 12 See infra 1. Clive M. In its contemporary form—perhaps best illustrated by the business trust statute found in the U. But even when a closely held firm drops a core feature of the corporate form (typically the board of directors).S. ´ ´ ` ´ ´ the Japanese close corporation.S.1.1. Production.2. the British private corporation. as well as for limited liability. While these statutes are not corporate law statutes.2004 8:38am page 6 6 What is a corporation? governing the German Gesellschaft mit beschrankter Haftung (GmbH). the common legal counterparty in numerous contracts with suppliers. We mean this description literally: a firm is. and we shall occasionally address them explicitly. such as the German GmbH statute or the French SARL statute. see Hansmann and Mattei. Klaus J. 10 The American limited liability company statutes. We do not comment on why production is organized in this fashion. which are of relatively recent origin. See also infra 4. National Conference of Commissioners on Uniform State Laws. and customers.13 The first and most important contribu9 While group law is most developed in Germany.). Groups of Companies (1991). employees. 405. as an evolution of the basic Anglo-American private trust.. the American limited liability company is a highly flexible hybrid of corporate and partnership forms that does not impose either delegated management under a board structure or transferable shares as the default regime. Information Costs. For further discussion and references. 502. 11 The business trust is a statutory form that has developed in the U. 3 Journal of Financial Economics 305 (1976).g.3. jurisdictions. 62 American Economic Review 777 (1972). Groups of Companies in European Laws: Legal and Economic Analyses on Multinational Enterprises (1982). e. the ¨ French Societe a responsabilite limitee (SARL). It provides for what we term below affirmative asset partitioning.9 Much of what we say here also applies to firms that are governed by special statutes—such as those for limited liability companies10 or business trusts11— that omit one or more of the core characteristics from their default regime. are not the equivalent of the European close corporation statutes. supra note 2. in John W. 13 The nexus of contracts image of the firm originates with Michael Jensen and William Meckling.2.). such as the German Konzernrecht. Pratt and Richard J. building on Armen Alchian and Harold Demsetz.S. See. e. supra note 5.12 our analysis offers insight into the interpretation of these bodies of law. Robert Clark. Likewise. 1. See. Theory of the Firm: Managerial Behavior. Schmitthoff and Frank Wooldridge (eds. Hansmann and Kraakman. it shares the remaining characteristics and problems of this form.g. Agency Costs versus Fiduciary Duties. nor do we join the controversy over whether relationships among the firm and its participants can be described exhaustively in contractual terms. and the close corporation forms that are provided for in some U. in fact. a firm fundamentally serves as a nexus of contracts: a single contracting party that coordinates the activities of suppliers of inputs and of consumers of products and services. our analysis extends to important aspects of legal regimes addressed to the regulation of corporate groups. state of Delaware—the form is essentially an empty shell. 503 (1995). Rather.. Zeckhauser (eds. Uniform Limited Liability Company Act §§203. e.

or various other forms) are not legal persons. Its obvious advantage is to increase the credibility of the firm’s contractual commitments. Legal entities. in contrast to corporations.14 The core element of legal personality (as we use the term here) is what the civil law refers to as ‘separate patrimony. Elsewhere we have termed this asset-pledging effect of legal personality ‘affirmative asset partitioning’ to emphasize that it involves shielding the assets of the entity—the corporation—from the creditors of the entity’s managers and owners. supra note 2. What matters for our purposes is that the firm organizes production in large part by entering formal contracts with numerous other parties. 14 It is sometimes said that partnerships (or trusts. the converse of that created by limited liability. The pattern of creditors’ rights created by strong form legal personality is. such as the business corporation. as of other forms of organizational law. such as the firm’s investors. such as the partnership. of course. and that the firm is free not only to use and sell but—most importantly—pledge to creditors.2.’ This is the ability of the firm to own assets that are distinct from the property of other persons.2004 8:38am page 7 What is Corporate Law? 7 tion of corporate law. which are characterized only by the priority rule and not by liquidation protection. or are suppliers or customers of the firm. as security for the firm’s debts. In contrast to the priority rule just mentioned. This rule is shared by all modern legal forms for enterprise organization. there are two relatively distinct rules of law involved. Those who are uncomfortable with this use of the term ‘legal personality’ can simply ignore our use of that term here. This liquidation protection rule serves to protect the going concern value of the firm against destruction either by individual shareholders or their creditors. is to permit a firm to serve this role by providing for the creation of a legal person—a contracting party distinct from the various individuals who own or manage the firm. Jurists who take that view have. The consequence of this priority rule is that a firm’s assets are automatically pledged as security for all contractual liabilities entered into by the firm. a conception of legal personality that differs from ours.Kraakman / The Anatomy of Corporate Law Final Proof 25. including partnerships. The second rule—a rule of ‘liquidation protection’—provides that the individual owners of the corporation (the shareholders) cannot withdraw their share of firm assets at will. which is not important in itself and is not meant to suggest anything broader than what we say.15 Where corporations are concerned. . as opposed to the ‘weak form’ legal personality found in partnerships. in effect. nor can the personal creditors of an individual owner foreclose on the owner’s share of firm assets. thus forcing partial or complete liquidation of the firm. a claim on the firm’s assets that is prior to the claims of the personal creditors of the firm’s owners. The first is a priority rule that grants to creditors of the firm. that are characterized by both these rules—priority for business creditors and liquidation protection—can therefore be thought of as having ‘strong form’ legal personality. it is not found in some other standard legal forms for enterprise organization. and focus instead on the specific rules of law that we describe under that heading. It protects the assets of the The Structure of Business 55 (1984). 15 See Hansmann and Kraakman. Our own view is that legal personality is most helpfully viewed in terms of the rules of creditors’ rights we describe here.

since this promise would be unenforceable against personal creditors who were not party to the bargain. (The owners could bind themselves not to liquidate the firm simply by contract. Gower and Davies’ Principles of Modern Company Law 40–46 (6th ed. 17 See id.Kraakman / The Anatomy of Corporate Law Final Proof 25. . Not only would such provisions be cumbersome to draft and costly to monitor. today 16 To establish the priority of business creditors by contract.. It could not feasibly be replicated. The priority rule component of corporate legal personality requires special legal doctrine to be effective. but they would be subject to a high degree of moral hazard—an individual owner could breach her promise to subordinate the claims of her personal creditors on the firm’s assets with impunity. a firm’s owners would have to contract with its business creditors to include subordination provisions. Some important corporate jurisdictions long made unlimited shareholder liability for corporate debts the governing rule. which determine when an agent has power to bind her principal to contracts. See Hansmann and Kraakman.2004 8:38am page 8 8 What is a corporation? firm from the creditors of the firm’s owners. and have no further claim against the personal assets of the firm’s shareholders (or managers). arguably also require background rules of law. while limited liability protects the assets of the firm’s owners from the claims of the firm’s creditors. and in the American state of California shareholders bore unlimited personal liability for corporation obligations until 1931.16 The same is true of the liquidation protection feature of corporate law so far as it binds the creditors of a firm’s owners.18 Nevertheless. The Proprietary Structure of Corporate Law (Working Paper 2001). Strong form legal personality reinforces the stability and creditworthiness of the firm and.17 1. including in particular partnerships. isolates the value of the firm from the personal financial affairs of the firm’s owners sufficiently to permit the firm’s shares to be freely traded. See Paul L. and hence constitute an exception to this statement. Davies. simply by contracting among a business’s owners and their creditors because contracts among these parties cannot bind the individual creditors of the firm’s owners. which could all in theory be crafted by contractual means even if the law did not provide for a standard form of enterprise organization that embodies them. See John Armour and Michael Whincop. supra note 2. as members of partnerships in fact often do. limited liability has not always been associated with the corporate form.2. 11 Journal of Corporate Law 573 (1986).) This distinguishes legal personality from the other four basic elements of the corporate form discussed here. Phillip Blumberg. with respect to business assets. in all contracts between individual owners and individual creditors. Authority doctrines. in the absence of such doctrine. 407–9. 1997).2. This limitation of owner liability distinguishes the corporate form from some other important forms of organization that have legal personality (as we define the latter feature here). and which form a component of the fourth characteristic (delegated management) of the corporate form described here. Limited Liability and Corporate Groups. 18 Limited liability did not become a standard feature of the British law of joint stock companies until the mid-nineteenth century.2 Limited liability The corporate form effectively imposes a default term in contracts between a firm and its creditors whereby the creditors are limited to making claims against the assets that are the property of the firm itself. Historically. when combined with limited liability.

conversely. In an enterprise of any substantial magnitude. 100 Yale Law Journal 1879 (1991). while corporation assets are reserved for corporation creditors. limited liability can play a valuable contracting role even in situations where a corporation has a single shareholder who does not require the corporate form to raise equity capital. in situations in which the latter parties are in a better position to bear those risks. This evolution indicates strongly the value of limited liability as a contracting tool and financing device. and thus serves as a kind of floating lien favoring business creditors over the individual creditors of investors and managers..2. limited liability permits flexibility in the allocation of risk and return between equityholders and debtholders. which those creditors are in a good position to evaluate and monitor and which creditors of the corporation. but may have little ability to monitor the corporation’s other ventures. by virtue of limited liability. Those creditors are commonly well positioned to assess and keep track of the value of those assets. which those creditors have a comparative advantage in evaluating and monitoring. as subsidiaries. Toward Unlimited Shareholder Liability for Corporate Torts. are not in a good position to check. Conversely. As a consequence. 43 University of Chicago Law Review 499 (1976). at lower cost than can the affirmative asset partitioning established by the doctrinal element of legal personality. It permits creditors of the corporation to have first claim on the corporation’s assets. Thus. supra note 2. legal personality and limited liability together set up a default regime whereby a shareholder’s personal assets are pledged as security to his personal creditors. and 19 See Hansmann and Kraakman.2004 8:38am page 9 What is Corporate Law? 9 limited liability has become a nearly universal feature of the corporate form. legal personality and limited liability together can reduce the overall cost of capital to the firm and its owners.19 While legal personality permits the business to own assets. the formation of corporations and subsidiary corporations can be used as a means of sharing the risks of transactions with the parties with whom a firm contracts. reduces transaction costs of collection in case of insolvency. distinct ventures or lines of business. A related aspect of asset partitioning is that limited liability permits firms to isolate different lines of business for the purpose of obtaining credit.Kraakman / The Anatomy of Corporate Law Final Proof 25. the assets associated with each venture can conveniently be pledged as security just to the creditors who deal with that venture. By separately incorporating. Note that the defensive asset partitioning established by a rule of limited liability is less fundamental. The Rights of Creditors of Affiliated Corporations. Elsewhere we have described limited liability as ‘defensive asset partitioning’ to distinguish it from the ‘affirmative’ partitioning effects of legal personality.g. e. limited liability reserves shareholders’ individual assets exclusively for their personal creditors. Richard Posner. 20 See. it permits an individual’s personal creditors to have first claim on personal assets. Id.20 Beyond this function of defensive asset partitioning. Thus. Henry Hansmann and Reinier Kraakman. in the sense that it can be achieved by contract. without statutory fiat. this allocation generally increases the value of both types of assets as security for debt. Finally. . as in the case of the parent company of a wholly owned subsidiary.

Transferability permits the firm to conduct business uninterruptedly as the identity of its owners changes. they may not be tradable without restriction in public markets. . 22 See Hansmann and Kraakman. Woodward. For these reasons. Limited liability to involuntary creditors is arguably not a necessary feature of the corporate form.2004 8:38am page 10 10 What is a corporation? simplifies and substantially stabilizes the pricing of stock21—something we shall say more about below in the discussion of transferability of shares.Kraakman / The Anatomy of Corporate Law Final Proof 25.. Fully transferable shares do not necessarily mean freely tradable shares. thus avoiding the complications of member withdrawal that are common among. such as third parties who have been injured as a consequence of the corporation’s negligent behavior. 1. Even if shares are transferable. The compelling reasons for limited liability in contract generally do not extend to limited liability in tort— that is. However. free tradability can also make it difficult to 21 See. 141 Journal of Institutional and Theoretical Economics 601 (1985). Paul Halpern. partnerships. limited liability enlists creditors as monitors of the firm’s managers. It also gives the firm maximal flexibility in raising capital. by shifting downside business risk from shareholders to creditors. An Economic Analysis of Limited Liability in Corporation Law. Susan E. e. 52 University of Chicago Law Review 89 (1985). Limited liability also plays an important function—but more subtle and less often remarked—in facilitating delegated management. which is the fourth of the core characteristics of the corporate form. nor even a socially valuable one. but rather just transferable among limited groups of individuals or with the approval of the current shareholders or of the corporation.g. cooperatives. a task which they may be in a better position to perform than are the shareholders in a firm in which share ownership is widely dispersed. all jurisdictions provide for free tradability as the default regime for at least one class of corporations (sometimes referred to as ‘open’ corporations). Free tradability maximizes the liquidity of shareholdings and the ability of shareholders to diversify their investments. and mutuals. Limited Liability in the Theory of the Firm. as we discuss more thoroughly in Chapter 4. for example. Limited Liability and the Corporation. Frank Easterbrook and Daniel Fischel.22 We should emphasize that when we refer to limited liability.3 Transferable shares Fully transferable shares in ownership are yet another basic characteristic of the business corporation that distinguishes the corporation from the partnership and from various other standard-form legal entities as well.2. limited shareholder liability to persons who are involuntary creditors of the corporation.2. This in turn enhances the liquidity of shareholders’ interests and makes it easier for shareholders to construct and maintain diversified investment portfolios. we mean specifically limited liability in contract—that is. Michael Trebilcock and Stuart Turnbull. supra note 2. In effect. 30 University of Toronto Law Journal 117 (1980). limited liability to voluntary creditors who have contractual claims on the corporation.

Consequently. which lacks all of these features. 1. The authority issue. and are all features of the standard corporate form everywhere. Organizational forms differ. as in a large general partnership that fails to allocate authority by agreement and to signal this allocation of authority clearly to third parties. is closely connected both with the liquidation protection that is a feature of strong form legal personality. the board is. unlike the corporation form. exclusively or primarily. separate from the operational managers of the corporation. perhaps fundamentally. while other jurisdictions simply provide for restraints on transferability as an option under a basic corporation statute. and transferable shares tend to go together. limited liability. or limited liability companies.2. such as partnerships. such as the special European statutes for close corporations. This is in contrast to the conventional general partnership. Perhaps more importantly. business corporations are distinguished by a governance structure in which all but the most fundamental decisions are put in the hands of a board of directors that has four basic features. Absent either of these rules. But those forms. they often do. corporate law typically vests principal authority over corporate affairs in a board of directors or similar committee organ that is periodically elected. as the identity of its shareholders changed. Sometimes this is done by means of a separate statute. by the firms’ shareholders. By contrast. Equally important. The limited partnership and the commonlaw private trust. in particular. all jurisdictions also provide mechanisms for restricting transferability.2. as we have already suggested. in fact. the creditworthiness of the firm as a whole could change.Kraakman / The Anatomy of Corporate Law Final Proof 25. for example.4 Delegated management with a board structure Delegated management is an attribute of nearly all large firms with numerous fractional owners. and with limited liability. business trusts. Transferability of shares. the value of shares would be difficult for potential purchasers to judge.23 First. a seller of shares could impose negative or positive externalities on his fellow shareholders depending on the wealth of the person to whom he chose to sell. in the way in which they delegate management power and authority. typically invest full control rights in a general partner or trustee who cannot be displaced without cause.2004 8:38am page 11 What is Corporate Law? 11 maintain negotiated control arrangements. quickly becomes intractable in a firm in which numerous owners and managers are not distinct. cannot have a board structure similar to that of a typical corporation. at least as a formal matter. Consequently. . It is therefore not surprising that strong form legal personality. do not presume a board of directors as a matter of law. The nature of this separation varies according to 23 This is not to say that other legal entities. however. delegation of decisionmaking power to specific individuals notifies third parties as to who in the firm has the authority to make binding agreements. More specifically. Delegation permits the centralization of management necessary to coordinate productive activity.

Beyond this. which are the province of the board. This formal distinction between the board and hired officers facilitates a separation between. the corporate form enhances the probability that those individuals will respond in a principled fashion to the interests of all corporate constituencies simply through moral principles and social pressure. .2004 8:38am page 12 12 What is a corporation? whether the board has one or two tiers.24 It also performs the key function—noted earlier—of permitting third parties to rely on a well-defined institution to formally bind the firm in its transactions with outsiders.Kraakman / The Anatomy of Corporate Law Final Proof 25. That separation serves as a useful check on the quality of decision-making by hired officers. or even dominate. are not strongly protected by contract. which is the province of hired officers. initiation and execution of business decisions. the board is formally distinct from the firm’s shareholders. and on the other hand the monitoring and ratification of decisions. such as employees or creditors. which is at least nominally independent from the firm’s hired officers (i. such as nonprofit corporations or business trusts. The obvious utility of this approach is to help assure that the board remains responsive to the interests of the firm’s owners. Third. Membership on the board can likewise provide minority shareholders or other constituencies. This separation economizes on the costs of decision-making by avoiding the need to inform the firm’s ultimate owners and obtain their consent for all but the most fundamental decisions regarding the firm. unlike those of other corporate constituencies. who bear the costs and benefits of the firm’s decisions and whose interests. that permit or 24 See Eugene Fama and Michael Jensen. top corporate officers occupy the board’s second (subordinate) tier. quite apart from formal legal or electoral accountability. the board itself. hired officers may be members of. a separately-constituted board can also provide a check on opportunistic behavior by controlling shareholders—either toward their fellow shareholders or toward other parties who deal with the firm. on the one hand.e. from the firm’s senior managerial employees). with a means for obtaining credible access to information or direct participation in firm decision-making. Also. Regardless of the actual allocation of power between a firm’s directors and officers. by assigning designated individuals a specific role as decision-makers on behalf of the enterprise. and the hiring of the officers themselves. but are generally absent from the first (supervisory) tier. such as creditors or employees—by providing a convenient target of personal liability for decisions made by the firm. This requirement of an elected board distinguishes the corporate form from other legal forms. In two-tier boards. Agency Problems and Residual Claims.2. the board of a corporation is elected—at least in substantial part—by the firm’s shareholders. 26 Journal of Law and Economics 327 (1983). In single-tier boards. Second. in contrast. the legal distinction between them formally divides all corporate decisions that do not require shareholder approval into those requiring approval by the board of directors and those that can be made by the firm’s hired officers on their own authority.

and of the relationship between these forms and the different bodies of organizational law that govern them. This structure—as opposed. to a structure concentrating authority in a single trustee. business corporations could. . including its service as shareholder representative and focus of liability. 1. a special 25 For a discussion of the varieties of forms of ownership found in contemporary economies and their respective economic roles. in which control and profits are tied to supply of a particular type of input. For example. But the law provides. More specifically. the board ordinarily has multiple members. Indeed.2. but do not require election of the board by the firm’s (beneficial) owners. instead.2. which may be the amount of inputs supplied to the firm (in the case of a producer cooperative). most close corporation statutes. most of the board’s legal functions. There are other forms of ownership that play an important role in contemporary economies. can be discharged effectively by a single elected director who also serves as the firm’s principal manager. or profits. and often permit the latter as an option as well— allocate voting power and shares in profits proportionally to acts of patronage. such as those governing Germany’s GmbH or France’s SARL. for a very small corporation.Kraakman / The Anatomy of Corporate Law Final Proof 25. as we use the term ‘ownership’ here: the right to control the firm. As a consequence. or the amount of the firm’s products purchased from the firm (in the case of a consumer cooperative). there are exceptions. However. and the right to receive the firm’s net earnings. cooperative corporation statutes— which provide for all of the four features of the corporate form just described except for transferable shares. The Ownership of Enterprise (1996). permit business planners to dispense with a collective board in favor of a single general director or one-person board—the evident reason being that. business corporations are effectively a special kind of producer cooperative. as in many private trusts—facilitates mutual monitoring and checks idiosyncratic decision-making.5 Investor ownership There are two key elements in the ownership of a firm. namely capital. in principle.25 For example. Fourth. both the right to participate in control—which generally involves voting in the election of directors and voting to approve major transactions—and the right to receive the firm’s residual earnings. The law of business corporations is principally designed to facilitate the organization of investor-owned firms—that is.2004 8:38am page 13 What is Corporate Law? 13 require a board structure. are typically proportional to the amount of capital contributed to the firm. Business corporation statutes universally provide for this allocation of control and earnings as the default rule. see Henry Hansmann. in an investor-owned firm. be formed under a well-designed general cooperative corporation statute. for example. and other bodies of organizational law—including other bodies of corporate law—that are specifically designed to facilitate the formation of those other types of firms. firms in which both elements of ownership are tied to investment of capital in the firm.

28 Specialization to investor ownership is yet another respect in which the law of business corporations differs from the law of partnership. creditors or employees—participate to some degree in either control or net earnings or both. assets. Oliver Williamson. it is also commonly used to assign ownership of the firm in whole or in part to contributors of labor or of other factors of production—as in the prototypical two-person partnership in which one partner supplies labor and the other capital. supra note 25. and that signals clearly to all interested parties the particular character of the firm with which they are dealing. and deviation from this pattern can be awkward.26 This specialization follows from the dominant role that investor-owned firms have come to play in contemporary economies. investors are often the most difficult to protect simply by contractual means. or by developing a separate and more adaptable form for closely held corporations. Worker codetermination is a conspicuous example. as the corporate form has evolved. One is that. As a consequence. among the various participants in the firm. The partnership form typically does not presume that ownership is tied to contribution of capital. Nevertheless. The dominance of investor ownership among large firms. either by permitting greater deviation from the default rules in the basic corporate form (e. through restrictions on share ownership or transfer). in turn. and the consequent advantages of having a form that is specialized to the particular needs of such firms. ownership shares in a business corporation can be granted to contributors of labor or other factors of production. thus preventing the formation of investor-owned firms under the cooperative corporation statutes.27 Another is that investors of capital have (or can be induced to have) peculiarly homogeneous interests among themselves.Kraakman / The Anatomy of Corporate Law Final Proof 25. To be sure. or in proportion to consumption of the firm’s services. 26 Cooperative corporation statutes.2. 27 See. . Kaplan and Per Stromberg.’ as we might think of them).2004 8:38am page 14 14 What is a corporation? statutory form for corporations owned by investors of capital (‘capital cooperatives.g.. 29 Stephen N. 70 Review of Economic Studies 281 (2003). Moreover. and control between entrepreneurs and investors in high-tech start-up firms offer a familiar example. commonly prohibit the grant of ownership shares— voting rights and rights to a share of profits—to persons who simply contribute capital to the firm. 28 See Hansmann.g. hence minimizing the potential for costly conflict among those who share governance of the firm. e. Financial Contracting Theory Meets the Real World: An ¨ Empirical Analysis of Venture Capital Contracts. reflects several conspicuous efficiency advantages of that form. and though it is often used in that fashion..29 Sometimes corporate law itself deviates from the assumption of investor ownership to permit or require that persons other than investors of capital— for example. with sufficient special contracting and manipulation of the form. Corporate Governance. the business corporation is less flexible than the partnership in terms of assigning ownership. 93 Yale Law Journal 1197 (1984). the default rules of corporate law are generally designed for investor ownership. it has achieved greater flexibility in assigning ownership. The complex arrangements for sharing rights to earnings. in turn.

Kraakman / The Anatomy of Corporate Law Final Proof 25. tends to exhibit most or all of the core characteristics of the corporation form. and the British private corporation—to exhibit all of the canonical features of the corporate form.2. and statutory business trusts. the Japanese close corporation. or at least are permitted to have. the civil law foundation and association.2004 8:38am page 15 What is Corporate Law? 15 The wisdom and means of providing for such non-investor participation remains one of the basic controversies in corporate law.1 Secondary and partial corporations forms First.S. all major jurisdictions have multiple secondary or partial corporate law statutes. do not trade freely in a public market. and the UK company limited by guarantee—that provide for formation of nonprofit firms. nonprofit corporation. Nevertheless. we will explicitly use the term ‘business corporation’ to make specific reference to the investor-owned company that is our principal focus. These nonprofit corporations. though transferable at least in principle. 1. they have no owners). Thus. But a body of statutory or decisional law belongs to corporate law only to the extent . corporate law as we understand it here generally extends well beyond the bounds of this core statute. however. Most jurisdictions also have one or more corporate forms—such as the U. These are firms in which no person may participate simultaneously in both the right to control and the right to residual earnings (which is to say. When there is potential for ambiguity. Partial corporate law statutes provide for separately defined statutory entities that have.3 What Does Corporate Law Include? All jurisdictions have a least one statute that establishes a basic corporate form with the five characteristics described above. Examples include limited partnerships. By contrast. we refer only to the business corporation. like cooperative corporations. such as typical American limited liability company statutes and business trust statutes. limited liability companies. will not be within the specific focus of our attention here. We shall of course address this subject further in Chapter 3. Secondary statutes include separate statutes for special classes of firms such as foreign firms or governmentally owned enterprise.3. some but not all of the five core characteristics described above. the French SARL. Large scale enterprise. are not corporate law statutes. To the extent that these forms include the core characteristics of the corporation. the American close corporation. when we use the term ‘corporation’ in this book. 1. We consider close companies—the German GmbH. statutes that merely permit business planners to create firms with the legal characteristics of business corporations. our discussion will help to illuminate their role and structure. regardless of its statutory origins. They differ from public companies chiefly because their shares. and not to other types of incorporated entities.

the parallel law of corporate groups is judge-made rather than statutory. such as the UK’s City Code rules on takeovers and mergers. or at least responds to. are incorporated in statutes or decisional law that are separate from basic corporate law. and imposing detailed disclosure rules. importantly structures board representation by establishing elaborate election procedures. as can other forms of self-regulation. Either way. the statutory rules in many jurisdictions that require employee representation on a corporation’s board of directors—such as. Konzernrecht is clearly an integral part of German corporate law. the rights of controlled companies are delimited by this statute itself. because they impose a detailed structure of employee participation on the boards of directors of large corporations. 30 We term such self-regulation a source of ‘law’ in part because it is commonly supported. these characteristics. and from the alternative forms just described. To begin.Kraakman / The Anatomy of Corporate Law Final Proof 25. or Konzernrecht. (We describe the German Konzernrecht in greater detail in Chapter 4. seeking to protect the creditors and minority shareholders of corporations with controlling shareholders. directly or indirectly. Stock exchange rules. It does not belong to the extent that it is merely an empty vessel within which planners may. at least in some jurisdictions.30 These supplemental bodies of law are necessarily part of the overall structure of corporate law.) Similarly. however. The self-regulatory authority of the American stock exchanges. . Where subsidiaries are organized under the close corporation statute (GmbH-Gesetz).2. which can regulate numerous aspects of the internal affairs of exchange-listed firms. conspicuously. is both reinforced and constrained by the U. which applies to large corporations. Where subsidiaries are organized under the open corporation statute (Aktiengesetz). by contracting. can also serve as an additional source of corporate law.2004 8:38am page 16 16 What does corporate law include? that it provides for. create a contractually-devised corporate form. the analysis offered in this book also offers insight into the interpretation of those bodies of law where they are used to form entities that share the characteristics of business corporations. On the other hand.S. Securities Exchange Act and the administrative rules promulgated by the Securities and Exchange Commission under that Act. for example.2 Additional sources of corporate law There are bodies of law that. American securities law.3. but that are nonetheless exclusively concerned with particular core characteristics of the corporate form as we define them here. regulating transferability of shares in various contexts. which provides for the regulation of both contractually formalized group relationships and de facto control relationships among corporations. the well-known German law of groups. and we shall be concerned here with all of them. by law in the narrow sense. the German or Dutch law of codetermination—qualify as elements of corporate law even though they occasionally originate outside the principal corporate law statutes. qualifies limited liability and limits the discretion of boards of directors in corporations that are closely related through cross ownership. 1.

In cases such as these. Nevertheless. Bankruptcy Code. of course. For example. although the types of firms that typically organize as corporations present particular problems for tort liability—especially when it comes to the liability of the corporation for the acts of corporate employees—these and other problems addressed by tort law are often presented by other types of entities.S. the reorganization provisions under Chapter 11 of the U. There are. criminal law. or tort law—that must be addressed here. While. some exceptions. The extension of limited liability beyond contract to tort. in some jurisdictions. to some degree. particular problems. but apply as well to partnerships and even individuals. those problems are not so distinctively connected to the core features of a corporation as to lead us to address them here as part of what we consider basic corporate law.4 What is the Goal of Corporate Law? What is the goal of corporate law. .’ as it is termed in the UK. The problems of labor contracting presented by large firms are. we do not treat most aspects of bankruptcy law here as part of corporate law. as distinct from its immediate functions of defining a form of enterprise and containing the conflicts among the participants 31 For example. Bankruptcy law plays an important role in enforcing the claims that derive from this partitioning. which has come to be considered a basic feature of the corporate form nearly everywhere. while most commonly invoked by companies.Kraakman / The Anatomy of Corporate Law Final Proof 25. Similarly. in each of those areas. Much the same is true. however. a major contribution of the corporation as a legal form is the ability to partition assets for purposes of pledging them as security to different groups of creditors.3 Non-corporate law constraints 17 There are. are not confined to such entities.3. the problems of bankruptcy presented by corporations are often shared by other types of legal entities. confined to entities formed as business corporations. and the elements of bankruptcy law that address those problems are not. and labor law. and therefore do not fall within the scope of corporate law as we define it here. while formally an aspect of bankruptcy law. for the types of issues traditionally considered within the realm of contract law. labor.2.31 Consequently. is another exception. many constraints imposed on companies by bodies of law designed to serve objectives that are largely unrelated to the core characteristics of the corporate form. addressed by specific regulation of the basic elements of the corporate form as we have described them here. As we have noted. 1. firms organized as corporations present. Bankruptcy law. in many jurisdictions. is an example. moreover. focuses specifically on the duties of corporate directors. such as the composition of the firm’s board of directors. and we do not address them here directly.2004 8:38am page 17 What is Corporate Law? 1. or ‘insolvency law. the UK doctrine of ‘wrongful trading’ in insolvency. there is a blurring of the boundaries between corporate law and other fields of law—bankruptcy.

more modestly. More particularly. While each of the authors of this book have individual views on this claim. that focusing principally on the maximization of shareholder returns is. workers. much less to maximize that number—and particularly so when many benefits are in appreciable part non-pecuniary. permits corporate shareholders to enrich themselves through transactions that make creditors or employees worse off by $2 for every $1 that the shareholders gain. in which case they neither describe corporate law as we see it. It is sometimes said that the goals of corporate law should be narrower. in particular. with benefit—to third parties such as local communities and beneficiaries of the natural environment. . Second. we do not take a strong position on it in the Chapters that follow. We believe that this second view is—and surely ought to be—the appropriate interpretation of statements by legal scholars and economists asserting that shareholder value is the proper object of corporate law. In general. First. There is no coherent way to put a number on society’s aggregate welfare. There would be little to recommend a body of law that. creditors. nor do they offer a normatively appealing aspiration for that body of law. to maximize the market price of corporate shares. the overall objective of corporate law—as of any branch of law—is presumably to serve the interests of society as a whole. we undertake the broader task of offering an analytic framework within which this question can be explored and debated. not just to the shareholders. if possible. to maximize financial returns to shareholders or.2004 8:38am page 18 18 What is the goal of corporate law? in this enterprise? As a normative matter. it is sometimes said that the appropriate role of corporate law is simply to assure that the corporation serves the best interests of its shareholders or. What we are suggesting here might be put more precisely in the language of welfare economics as pursuing Kaldor-Hicks efficiency within acceptable patterns of distribution. and customers will consent to deal with a corporation only if they expect to be better off themselves as a result. for example. the pursuit of shareholder value is generally an effective means of advancing social welfare is an empirical question on which reasonable minds can differ. employees. more specifically. these claims can be taken at face value. In particular. the appropriate goal of corporate law is to advance the aggregate welfare32 of a firm’s shareholders. Consequently. such claims can be understood as saying. its shareholders—has a direct pecuniary interest in making sure that corporate transactions are beneficial.2. but to all parties who deal with the firm. Whether. suppliers. 32 When we speak here of advancing or maximizing the ‘aggregate welfare’ of society we are using a metaphor that is conceptually a bit loose. more specifically still. and customers without undue sacrifice—and. in general. Rather.Kraakman / The Anatomy of Corporate Law Final Proof 25. This is what economists would characterize as the pursuit of overall social efficiency. Such claims can be viewed in two ways. the corporation—and. in fact. the best means by which corporate law can serve the broader goal of advancing overall social welfare.

corporate law everywhere continues to bear the imprint of the historical path through which it has evolved.2. or organized workers. to a greater or lesser degree. of course.Kraakman / The Anatomy of Corporate Law Final Proof 25. such as corporate managers. . The corporate law of all jurisdictions clearly shows. Legislatures and courts are sometimes less attentive to overall social welfare than to the particular interests of some influential constituency. and reflects as well various non-efficiency-oriented intellectual and ideological currents that have sometimes influenced its formation. that the law always serves that goal. controlling shareholders. the weight of these various influences.2004 8:38am page 19 What is Corporate Law? 19 To say that the pursuit of aggregate social welfare is the appropriate goal of corporate law is not to say. Moreover.

Kraakman / The Anatomy of Corporate Law Final Proof 25.2.2004 8:38am page 20 .